Spirit Realty Capital Inc (SRC) 2005 Q1 法說會逐字稿

Please stand by, we're about to begin. Good afternoon and welcome to the Spirit Finance Corporation First Quarter Earnings Release Conference Call. Today's call is being recorded. At this time, all participants have been placed in a listen only mode and the floor will be open for your questions following the presentation. It is now my pleasure to turn the call over to Ms. Cathy Long, please go ahead.

Good afternoon, thank you for joining us on our first quarter conference call. I'm Cathy Long, Chief Financial Officer of Spirit Finance. Along with me on today's call is Mort Fleischer, Spirit's Co-Founder, Chairman and Chief Executive Officer, and Chris Volk, Spirit's Co-Founder, President and Chief Operating Officer.

Before we begin, I need to remind everyone that part of our discussion this afternoon will include forward-looking statements that are not guarantees of future performance and therefore undue reliance should not be placed upon them. We refer all of you to our filings with the Securities and Exchange Commission for a more detailed discussion of the risks that may have a direct bearing on our operating results, performance and financial condition. And with that, I'll pass the call to Mort.

Thank you Cathy and thank you for joining us today on our conference call to review our first full quarter of public comments. The format for today's call will be as follows. I will provide and overview of the market and some additional thoughts about our progress to date. Then Cathy will review our financial performance in the quarter and review guidance for 2005.

Chris will then discuss operations and make some additional remarks and open the floor to questions. Whenever I have the opportunity to talk with our shareholders, I find they are looking for my view of the overall market. We formed Spirit with the intent of helping our customers build their shareholder value through the use of more efficient real estate capitalization strategies.

Our vision is to address the very large investment market and in that process to make sound investments which capture attractive spread income and total investor rates of return. I want to say that we're making significant progress. During this year, we have continued our extensive targeted direct calling efforts which have translated into substantial investment opportunities.

We are in a world that is more awash with capital than most of us have ever seen. The temptation exists to make investment decisions which sacrifice investment quality for the sake of producing level quarter to quarter volume. We will not do this. Anyone who has been in business many years and understands that undue importance should not be placed in any one quarter's investment activity.

We will continue to maintain our investment philosophy and follow the underwriting guidelines and investment principals which have made us successful in the past by investing wisely with a long term perspective. In our many years of prior real estate investment experience, the acquisition pace has varied substantially from quarter to quarter.

The first quarter has generally been the smallest, the second very good, the third a little slower and the fourth, a grand slam as year end approaches. The second half was always better than the first, a seen pattern appears to be developing at Spirit Finance. Whether this pattern of productivity will continue remains to be seen as Spirit continues to grow.

Due to this uneven investment activity during our quarterly calls, we will provide annual investment activity guidance updates and a projected range of production for the following quarter. With these thoughts as a backdrop and with favorable reception to our ideas from our existing and potential customers, we are reiterating our expected minimum 2000 investment volume of $800 million. I will now turn the call back to Cathy.

Thank you, Mort. I'll start by providing a review of our first quarter results. Then I'll provide an update on our real estate portfolio and also review our guidance for 2005. For the first quarter, we reported FFO of $10.2 million and AFFO of $10 million. Although the weighted shares outstanding increased 66% between the fourth quarter of 2004 and the first quarter of 2005, FFO per share remained unchanged at $0.15 per diluted share with the benefit of the full quarters revenue from real estate acquisitions made late in the fourth quarter of 2004.

It is important to note that because we actively seek to include a CPI component in our leases, most of our lease escalations do not require us to report straight line rent revenue. As a result, straight line rent revenue is relatively small and FFO and AFFO are nearly the same. Almost all of Spirit's FFO is therefore recurring cash flow that will be increased through future investment activity and anticipated lease escalations.

Net income was $6.8 million or $0.10 per diluted share on revenues of $15.6 million. The difference between AFFO and GAAP earnings for this quarter consisted of depreciation and amortization of $3.4 million, straight line rent of $247,000 and a $57,000 loss on the sale of properties.

Interest expense in the first quarter of 2005 included amortization of deferred financing costs associated with establishing our credit facilities as well as interest incurred on seller financing we put in place in 2004. The seller refinancing was repaid with IPO proceeds only late in the first quarter due to prepayment timing restrictions. If the seller financing had been repaid at the beginning of the quarter, FFO would have been $0.16 per diluted share.

Since we raised our first outside capital in December 2003, the first quarter of 2004 is not a meaningful comparison, nevertheless, to briefly review, we reported 2004 first quarter FFO of $1.1 million and AFFO of $1 million which both equated to $0.03 per diluted share. Net income was $800,000 or $0.02 per diluted share on revenues of $2.6 million.

Turning to our balance sheet, on March 31, 2005, we had $739 million in total assets, including $657 million in gross real estate investment, $41 million in mortgage loans receivables and $43 million in cash and cash equivalent. From a liability perspective, we had $97 million of debt including $38 million of fixed rate mortgages and notes payable and $59 million outstanding on one of our credit facilities. We're currently positioned to leverage our balance sheet giving us capacity to close our expected 2005 real estate acquisitions.

During the first quarter, we continued to make progress in developing our long-term liability strategy. First in March, we established an additional $125 million short term credit facility with Citigroup's global market realty corp, which increased our total credit line to $375 million. Second, we began to pursue further and expect to close on a number of CMBS funded investments. Finally, we continue to make progress on an expected term funding that will address the long-term funding needs on over $500 million in assets that are not currently subject to term borrowing.

To address our long-term spread, we've entered into forward starting interest rate swap agreements totaling over $300 million in notional amounts. In the first quarter we made acquisitions totaling $38 million in 12 properties. Our current gross real estate and mortgage loan portfolio of $698 million is geographically diversified across 38 states and among retail, distribution and service oriented property types.

The largest concentration of our real estate investment is in restaurants, consisting of 239 properties owned or financed and totaling 39% of our gross investment portfolio. The second largest area of concentration is movie theaters consisting of 11 properties and 17% of the portfolio, while the third largest grouping is specialty retailers consisting of 20 properties and reflecting 13% of our total portfolio.

We also disposed of 6 properties during the quarter totaling $8 million. These properties were consisting of non-strategic components of larger real estate acquisitions that we made during 2004. Generally, our properties are leased under triple net lease arrangements and the weighted average maturity of the non-cancelable portion of our leases is 15 years.

These long-term leases provide us a stable, long-term cash flow with less than 3% of our lease portfolio expiring prior to the year 2012. Turning to credit; the company's real estate portfolio was lease to finance to 55 companies with no credit exposure greater than 6.2% of the company's total investments.

At the end of the first quarter, our customer credit profile is unchanged from the fourth quarter of 2004. Fifty three percent of our existing portfolio is rated, of which 11% has an investment grade rating or the equivalent for non-public debt.

Across Spirit portfolio, the weighted average store fixed charge coverage approximates 1.7 to 1, with 70% of our investments subject to either store sales or store P&L reporting. Our 10 largest customers comprise 53% of the total dollar volume of our portfolio, as we more than double the size of our investment portfolio in 2005, we anticipate that the existing tenant concentrations will become even smaller.

All of the properties in our portfolio are occupied and are current in their payments, adding to the stability of our cash flow. Now I'll review our earnings guidance. As many of you know, it's not our policy to provide quarterly earnings guidance. On our last call, we provided 2005 annual FFO guidance as a range from $0.70 to $0.75 per diluted share.

This guidance is premised on completing at least $800 million in real estate acquisitions during 2005. We reaffirmed that annual guidance today. As Mort pointed out the pace and timing of acquisitions are likely to vary significantly from quarter to quarter and the first quarter is reflective of that reality.

From a timing perspective, we anticipate that the second and fourth quarters will have the largest acquisition volume this year. Our focus is to ramp up our acquisitions over the course of this year with the goal of making attractive investments for long term and stable cash flow.

Our pipeline is robust and we have a large variety of transactions to consider. Chris will discuss that in greater detail in just a moment. With regard to our dividend policy, our most recent dividend declared was $0.19 per share which was paid on April 25th. Management's goal is to continue to pay dividends at this level with future dividend use increases addressed annually. We expect to declare the next dividend on or around June 27th. With that, I'll now turn the call over to Chris.

Thank you. As Cathy mentioned, we closed on $38 million in 12 properties during the first quarter, which was an increase over the $11 million first quarter start last year. Second quarter activity is expected to be strong with investment activity projected to range from $250 million to $300 million.

Last year we closed $230 million in the second quarter on our way to a solid $600 million for our first full year of operations. Any variance in second quarter activity this year is expected to result principally from transaction spill over into the third quarter.

At the end of 2004, our net lease portfolio had a weighted average initial lease or cap rate of approximately 8.75%. During the last conference call, we noted that our expected 2005 cap rates were 25 basis points lower. A weighted average initial lease rate on the properties we acquired in the first quarter was 8.4% with expected weighted annual rent escalation of 2.1%, which is above our rent escalation average at the end of 2004. The industry is represented included restaurants, full profit education, specialty retail and wholesale distribution.

Four properties in the education sector accounted for $17 million, which was the largest transaction during the quarter. During the second quarter, our pipeline of expected and potential closings is expected to result in a weighted average initial lease rate that is slightly lower at 8.3% with annual lease escalations approximating a point and a half.

However, roughly a quarter of our expected future closings will be funded through efficient commercial mortgage backed securities funding. These leases bear typically lower lease rates due to the property type and high credit profiles of the tenant. At the same time, the efficient leverage of these investments allow for total expected returns that are within our target range.

Absent these properties, Spirit's weighted average initial lease rates for the expected Q2 closings will be 8.6% which is in line with our estimates of last quarter. Closings in the second quarter are expected to add to Spirit's diversity of retail, service and distribution property types with an average transaction size of $15 million across 22 customers.

As Mort indicated, we've worked hard to adhere to credit criteria as well as return criteria. Of the expected Q2 closings, 30% are rated BB or better versus around 10% in Q1. The non-rated credits are comprised generally of larger multi unit companies, investments that tend to be within replacement costs and or with rents that are supportable by market comparables and locations that are economically vital.

Turning to the targeted investment pipeline, potential investment stood at $2.3 billion as of May 2nd inclusive of pending Q2 acquisitions. Approximately 15% of the targeted pool is centered in the distribution property, 20% in service property with 65% centered in retail assets. The transaction size continues to average $24 million with a pipeline approaching 900 properties.

Twenty percent of the pipeline represents potential investments in newly built or to be built assets with 80% coming in the form of existing asset investment. The majority of the existing assets within the pipeline are expected to use our form of lease with less than 10% of the assets subject to existing leases.

Regarding size, we have several potential transactions ranging between $80 and $100 million, but the majority of remaining potential transactions are well below $50 million. The pipeline continues to be primarily internally generated by our five sales directors and senior Spirit officers.

Before making some concluding comments, I just wanted to spend a minute on our staffing and organization. During the first quarter, we welcomed Michael Bennet to the senior management team at Spirit. Michael is Senior Vice President of Operations and comes to us with more than 20 years of private and corporate legal experience.

As of today, our staff number is 30. During the remainder of 2005, we anticipate a few planned staff additions inclusive of added sales staff to augment our origination capacity. We built Spirit with operational efficiency in mind, anticipating meaningful reduction in G&A costs relative to assets over the next few years.

Let me now discuss some of Spirit's advantages. We offer customers a number of benefits such as flexible lease terms, full substitution rights and long-term commitments to holding their leases which most of our competitors do not. We have one of the strongest balance sheets in the industry; we're able to combine our cost to capital and operational structure with efficient leverage strategy to deliver competitively priced lease products.

We believe the market for operationally essential real estate is nexus of $1 trillion in size and needless to say, we have barely scratched the surface. In closing, let me reiterate, first, our strategy has served us well in the past and we're confident and we'll continue in the future as we continue to evaluate our initiatives on an ROE basis and to commit capital in areas where risk adjusted returns are attractive.

Second, the company employs a risk evaluation strategy that includes diversification by geography, property type and tenant. Attention to credit fundamentals including the credit paradigm employed by management for more than a decade and independent real estate valuation.

Third, our balance sheet and cash flow generation remains strong and supports our growth internally during 2005. Fourth, we made progress into finding the right side of the balance sheet in the first quarter, achieving the following. One, we raised our short term credit facilities to $375 million. Two, we began to take advantage of certain commercial mortgage backed securities investment opportunities. Three, we maintained a solid interest rate hedge position and fourth we are working towards a major structured finance initiative designed to provide spirit with a competitive cost of capital and financial flexibility in the future.

Finally, in closing, through our targeted direct calling efforts, we maintained a strong pipeline of potential acquisitions positioning ourselves to post strong second quarter investment activity and meet total 2005 investment objectives. Our customers typically have numerous choices for capital and have selected Spirit. With that said, operator, let's open the line for questions.

Thank you. (Operator Instructions).

We go first to Jim Sullivan of Green Street Advisors.

Thanks. Chris, the flattening of the yield curve, is that good for you or bad for you?

Well Jim, today, the three month treasury is at 284. I tend to like it because it means that companies that have been financing themselves short are going to look at long-term financing options and sale lease back or exactly that and they're going to view that as being a comparative advantage and a flat yield curve environment with the rates where they are.

I think that I can't speak for you but I think in a rate environment where long-term yields remain this low, as an investment paper are also likewise attractive and could be positioned to provide capital to those types of companies desiring to lock into low and affordable long-term rates. So we think it's a positive.

Are you seeing any evidence of that in your yield flow?

I can't say we've seen any spikes as a result of that. So, clearly, when we were talking to companies, especially some of the larger companies, one of our final slides is a flat yield curve. And when we talk to companies, its subject that hits home. It's one of the things we say, if you guys are going to do something like this, you should do some stuff like this now, because the time is very opportune.

And with respect to acquisition volume, you seem pretty wetted to the $800 million number for the full year. What assurance can you give us that you're not going to draw up your guard with respect to credit quality and or pricing in order to hit that target?

Well, as you know, we're first and foremost focused on returns as opposed to pricing and we're always focused on credit criteria. So I think that the best thing I could tell you Jim is that management and speaking for myself specifically, we have a lot of our network in the company. We are very long-term focused and credit criteria has a way of rearing its head if you don't pay attention to it.

If you look at the portfolio overall today, the coverage at store level Cathy said is an average of 170. We have select assets that probably are marginal but the select assets, when we mentioned we sold eight properties last quarter, those are the types of properties we've sold and those kinds of properties and assets where we think that we're concerned about long-term residual value. So we are meaningfully involved in making sure that we not only acquire good properties but we manage the quality of the portfolio going forward.

Then finally you mentioned becoming more active in CMBS, can you elaborate on that a bit, what you're doing?

Well, when you go to high credit tenants (audio gap) and the commercial mortgage backed securities market, we have another vehicle which is comprised primarily of sub investment grade assets which we're not sure is as efficient a vehicle which is why we're not using that vehicle.

The CMBS market is an extremely efficient market. I would say in most respects, from a rate perspective, it's more efficient than the credit tenant lease market today and CMBS market you can borrow at rates ranging from 95 to 110 over the 10 year treasury which, as you know, is exceptionally efficient. It's a, from a rate perspective, the amortization tends to be a 30 year amortization with a 10 year balloon which is also very efficient from a rate perspective.

So, if you're dealing with credit quality tenants and you want to be competitive, it is a great vehicle and is especially ideally suited for assets that are too small to merit doing a large and longer-term credit, lease transaction.

Thanks Chris.

We go next to Ross Nussbaum of Banc of America Securities.

Hi everyone good afternoon. Chris, a question, of the $250 to $300 million you talk about closing potentially this quarter, how much have you closed on already?

We closed on around $38 today.

Of that $250, $300?

Yes.

OK, and the yields that you've been discussing, are those the cash yields, not the GAAP yields?

Those are cash yields.

So, the escalation, you're going to be straight lining those escalations?

No.

You will not be?

As a general rule and you notice that in Cathy's comments on our first quarter results, AFFO and FFO are almost identical. The only difference was about $200,000 in straight line rent. And we tried hard to put a CPI component in our leases which allows us to not straight line the rent and I think that it helps us have a higher quality FFO number and offers less confusion. So we're really focused on what's the initial rate.

So we say to you that the initial rate for the first quarter closing was $840 and the escalation were two, that's $840 cash on cash going in, two a year going forward. We'd say that we've got $860 on the transactions absent CMBS fund financing and escalations of $150, that's $860 on a cash on cash basis, $150 average escalation going forward.

OK and a clarification, on the second quarter deals, it's eight three with a one and a half escalation?

It's eight three on a blended basis but you have to, again, that includes some fairly high quality tenant where the lease compression is going to be more noticeable.

OK, but it's eight six on the ones you're doing...

If you wanted to do it apples to apples, it's around eight six, which is about, in terms of the credit, in terms tenants that we were doing last year and this year. So we're within the 25 basis points that we were talking about.

OK and in terms of the $2.3 billion long-term pipeline, you walked through the breakout in terms of the property types. I just want to make sure I understand what you're saying. When you're saying 15% distribution, that's industrial space, correct?

It's really like warehouse distribution space, principally.

OK, is it any flex office or kind of is it pure industrial?

Associated with it, that's correct.

OK and then when you say service, what are you referring to?

Service relates to movie theaters for example or in the service business. So if you look at Citgo's (ph) and you look under service, that's what I'm referring to.

Gotcha. OK, that's all I have, thank you.

We go now to Michael Borman with Smith Barney.

Good afternoon guys. Can you split out the high yielding assets in the quarter, the $250 to $300, how much is the high credit, sorry and how much is the other?

I don't have that with me, Michael. You can almost do the math though because you've got $860 without them, $830 with them. And you've got $250 to $300 million so you can sort of almost see the math itself. But I would say it's about even. Let me look, I have a sheet here. I'm going to say it's probably $75 million give or take.

OK, and how much, you said $38 was closed, how much do you actually have under contract?

It's pretty much the balance, we don't sign purchase and sales up until the very end so if we're disclosing financial and we say, and we're pointing out hard and fast liabilities and obligations to close, the purchase and sale agreement doesn't get signed until almost the day of closing, so they are all under letters of intent and or signed commitment letters.

And Cathy, you were talking something about interest expense that I had missed. Can you go over that again? Something about being late?

Yes, we had some seller financing from last year that we had outstanding at year end that we were paying off with proceeds of the IPO. And because of prepayment timing restrictions, we were unable to pay it off on January 1. So...

How much was that and when was it paid off?

It was $140 million.

And you ended up paying it off nearing the end of the quarter?

No, at the beginning of March.

At the beginning of March. Was there any prepayment penalties or anything else in interest expense this quarter?

There was a small fee upon paying it off, but the majority of it was just the fact that had we been able to pay it off in January, we would have had an extra penny in FFO.

OK, and Chris, maybe you could talk a little bit about how the pipeline has changed since we last spoke on the last call. It sounds like it's the same amount but I'm wondering, maybe the composition as things come out or other things come in?

Michael, the pipeline is about the same dollar amount. In terms of composition, there's been a turnover of about 30%. So that means we've either declined transactions, transactions did not happen as we expected they would or we lost the transaction to somebody else.

If you were to put that into percentages in terms of what you lost or what you turned away just to get some sense...

I do not have that in front of me and I'd have to call you back and give you some sort of estimate.

OK. Talk a little bit about the $17 million for profit education investment?

It's four properties. I don't have the square footage right in front of me, they're actually in Arizona. They're owned by a pretty significant financial sponsor. They are trade schools that have been in business for a long time specializing in dental hygiene and paralegals and the kind. The building themselves was actually quite much like office buildings except with a lot of extra parking because you have obviously students there, so there's almost like office buildings with too much parking.

The assets in particular are exceptionally, they're exceptional assets and the uni-level performance on these as far as the coverage, they're probably more from three to one, one of them significantly more than that. The performance financially of these properties, of the schools themselves is exceptional.

And when you think about your pipeline in terms of additional education exposure, does that fall into the service category or do you, 20%?

That's service, yes.

That's in service.

Yes.

And how much of that 20% is education?

That's in our pipeline?

Yeah.

Let's see if we've got that broken down, just for a second.

Once again, if you'd like to ask a question, you may do so by pressing star one. We'll go now to Andrew Rockovetch (ph) of CSFB.

Hey, Andrew?

Yeah, I can hold off if you want to answer that question.

No problem, the number is 8% in the pipeline, so it's almost half of the 20%.

Should I get started?

Yeah.

OK, I'm here with Jessica Tulley (ph). Just to ask a question, I think I've asked you before Chris, especially with GM and Ford going to junk today and wider spreads in the debt market, theoretically speaking it would sound like you guys would get better pricing due to less attractive credit market for your potential clients. Is that happening or is there still a disconnect where net lease deals aren't getting impacted at all by what's happening in the credit market?

I would say that there is not a direct pass through of changes in spreads into net lease markets. I should also point out that we're pretty heavily hedged and when we hedge this we're hedging a swap spread. So were putting on forward (Inaudible) swaps and the pricing of the on balance sheet assets that we have not are subject to long-term leverage. So that that pricing will be done to swap spread and the hedges that we put on, we put on two principle hedges, one was put on with a 10 year at $417 and one was put on when the 10 year was a little bit higher than that, and therefore the 10 year is at $416.

Our swaps are actually underwater today, which basically tells you that swap spreads have come in since the time that we did that hedge so that you're pointing out the credit spreads have widened out that they've sort of, they've widened out recently but they're actually tighter when we put on our first swap spread.

OK, and Jessica has a question.

I wanted to ask you about macro environments because it still seems like you planned the $800 million in acquisitions, that you're probably more of them are back end loaded towards the end of the year than you would have expected earlier. What's changed from when you came public that's made the acquisition environment more difficult?

This is Mort, that's not true. Our business has consistently been as we've pointed out, first quarter is always slow because of the big bang in the fourth quarter. The third quarter is OK and fourth quarter is the big bang. It's just, in our past life it was that way and it may not stay that way here but it looks like it's going to be that way for at least for now.

OK, so things are pretty much moving along as you would have expected then? Great.

We'll go now to Art Havener of A.G. Edwards.

Good afternoon, to kind of follow up in terms of the acquisition, in terms of you reaching your year end guidance, how back end loaded is the acquisition volume that you're modeling? It looks like if you complete $250 to $300 million in the second quarter you're still left with $500 million or so to reach your goal. Should we be looking at kind of $100 million in the third quarter and $400 million or not skewed that significantly to the back end.

We can't necessarily specify exactly what quarter the rest of the year will fall into other than historically the fourth quarter is the largest.

OK, but if the fourth quarter does serve to be the large quarter again, do those generally fall at the end of the year, so they don't really have a quarterly impact.

Yes, the generally fall in December.

OK, and so if you do follow up, if you do close $250 or $300 million in the second quarter, you still feel comfortable with the guidance that you've provided?

Yes.

OK, thank you.

Again, that is star one for questions. At this time, we have no further questions, I'd like to turn the conference back to Mr. Fleischer for closing comments.

This is a year where we're going to be more than doubling the size of this company. As I said earlier, we don't intend to take undue risks or get in the way of quality here. There was a question along those lines and that's something, in the 80s, I remember when I was in business, I used to watch everybody in unlimited partnerships, I used to watch everybody doing these really sexy deals and they were the rabbit and I was the turtle.

Well, most of the rabbits are gone and I'm the turtle, I'm still around. So we don't intend to take undue risks and give away the quality you get or the kind of projections we're talking about. We continue to view the sale lease back as another financial tool for our clients and our whole reason for existence is to add value to the clients by lowering their cost to capital for what we call operationally essential real estate.

We're slowly, or maybe not so slowly now, getting that idea out into the world that we're not just straightening the real estate business, this is another financial tool and we can help you add value to your portfolio side. We're getting some traction with this idea. We're enthusiastic about our business and we're committed to our core strategies which we think will result in continued market share gains and of course long-term shareholder value for you and our sellers and shareholders. Thanks very much.

This does conclude our teleconference. Thank you for your participation, you may now disconnect.